Positioning Liquid Credit Portfolios For Rising Rates & Inflation
Martin Horne, Head of Global Public Fixed Income, discusses how to mitigate the risk of rising rates and inflation, touching on the potential benefits of floating rate assets and short-duration strategies.
How is today’s environment for rates and inflation similar to past cycles, and how is it different?
There are certainly similarities between the environment we’re in today and what we’ve seen in past cycles. For one, the rising inflation and potential for rates hikes that we’re grappling with is positioned against the backdrop of an economy that is in reasonable shape, as has been the case historically when at the early stages of rate-hiking cycles. That’s important to keep in mind despite the heightened market volatility that has characterized the early part of this year.
There are also unique elements to what we’re seeing today, mostly related to the underlying causes of the inflation we’re facing. Energy is clearly undergoing significant structural changes—accelerated by climate policy and the movement toward renewables—and prices have risen as a result. This has been further exacerbated by Russia’s invasion of Ukraine, with oil prices recently reaching multi-year highs and Brent crude surpassing $100 barrel for the first time since 2014. Supply chain disruption amid ongoing Covid flare-ups around the world is another contributing factor. While parts of the world are opening up, particularly developed markets, others are still experiencing manufacturing delays and disruptions. Finally, higher wages are also a contributing factor as the worker shortage continues in many parts of the economy even if there are debates around its exact cause. Government subsidies have been criticized for incentivizing workers to stay out of the active workforce, but even in areas where those subsidies have largely fallen away, like the U.S. and U.K., there are still record numbers of vacancies. One cause may be the reliance, particularly in more rural areas, on an transient workforce that was willing to travel and provided a supplemental supply of workers to sectors like agriculture and service. Another relates to the so-called “great resignation,” as workers over the last two years have changed their career path or removed themselves from the workforce altogether, either by choice or necessity.
One notable point with regard to the volatility we saw in fixed income markets earlier this year is that it may not have been tied to higher inflation itself, but more to investors trying to predict central banks’ reaction to it. As we saw in January, the realization that base rates may be moving up faster than expected pushed U.S. Treasury yield curves higher and caused equity markets to sell off. But that begs the question: do base rate movements actually control things like the deficit of workers, ongoing supply side disruptions, and structural deficits in the energy market? I think you can argue that’s a somewhat inadequate assumption, which suggests we may be more exposed to policy mistakes at this point.